Haven or Hell?

The IRS wants to crack down on multinational corporations that transfer U.S. intellectual property to tax havens.
Ronald Fink, CFO MagazineMarch 1, 2004

On the day in early January when talks over a long-running tax dispute between Glaxo SmithKline and the Internal Revenue Service broke off, Glaxo's share price fell nearly 2 percent. And no wonder. The IRS wants the U.K.-based pharmaceutical giant to cough up more than $5 billion in taxes, penalties, and interest, more than half of operating cash flow.

The dispute involves transfer pricing—specifically, the rate Glaxo charged for marketing services supplied by its U.S. affiliate from 1989 to 1996. The IRS maintains that the rate was far too low, and thus vastly understated Glaxo's income subject to U.S. tax during that period. Now the case is headed for the U.S. Tax Court, where hearings could begin as early as next year.

Corporate tax directors are taking a keen interest in the case—particularly at multinational enterprises, for which transfer pricing is the most important international tax issue. According to transfer-pricing experts, the IRS's decision to take Glaxo to court reflects new thinking on the part of the agency. They say the new thinking is enshrined in new regulations, proposed by the IRS last September. The rules would radically change how the U.S. tax authority treats services supplied to parent companies by affiliates in other tax jurisdictions (and vice versa)—including jurisdictions that offer enough tax incentives to be considered havens. "The new rules will allow the IRS to deal with this issue much more effectively," observes Deloris Wright, a principal in the Denver office of consulting firm The Analysis Group.

The proposed regulations have already spawned controversy, as was evident at an IRS hearing in mid-January. "Largely unworkable" was the judgment offered by Hank Wagner, senior counsel for the Mount Olive, New Jersey-based affiliate of German chemical maker BASF. Wagner's testimony cited the "enormous complexity" and "unreliability" of key provisions, which he said would impose compliance costs on multinational corporate taxpayers that would "exceed any benefit the new rule[s] will provide."

Others worry that the new rules could subject multinational companies to huge increases in U.S. taxes. The concern is particularly acute for midsize growth companies, says Jim Silvestri, director of worldwide taxes for Cognizant Technology Solutions Corp., a software developer based in Teaneck, New Jersey.

Heartburn for MultinationalsUnder current tax rules, transfer pricing of services can be reported at cost as long as those services are deemed not integral to the business. Those that are integral must be priced as if they were offered by a third party, which usually amounts to cost plus a markup that would be appropriate in an arm's-length transaction. What's integral, of course, is subject to interpretation, as is the question of a suitable markup. And as Glaxo and other cases show, the IRS has had some difficulty getting the tax court to side with it.

The proposed new rules do away with the safe harbor for nonintegral services. Instead, they require those services to be priced, for starters, at cost-plus (called the simplified cost-based method). The markup must be demonstrably close to what is available from a third party. If the third-party markup exceeds 10 percent, a company would have to use one of five other methods (see "No Ports in This Storm," at the end of this article).

Certain services, such as insurance and research and development, are explicitly excluded from the simplified cost-based method, while others may not qualify because they fall into such broad but ambiguous categories as "valuable" or "unique" (see "More Fine Print," at the end of this article). Companies worry that even some low-margin back-office services won't qualify for cost-plus treatment.

Not surprisingly, the IRS contends that any additional tax burden for multinationals resulting from the new rules may be completely appropriate. To understand why, consider the Glaxo case, which focuses on the firm's popular ulcer drug, Zantac. Observers note that Glaxo depends heavily on marketing and distribution efforts in the United States for sales of Zantac in this country. Those services are performed through a U.S.-based affiliate. Meanwhile, Glaxo's R&D efforts for the drug are conducted in the United Kingdom.

According to the IRS, much more of Zantac's value is derived from marketing efforts than from R&D, because the drug is number two in the market. The IRS's position is that R&D may explain the success of a "pioneer" drug (that is, the first product to treat a given disease state); however, subsequent market entrants are successful primarily due to the marketing acumen of the company. But Glaxo's transfer pricing doesn't reflect that value. Glaxo contends that Zantac's value is largely produced by R&D, because the drug is different enough to make the U.K. patent that Glaxo holds on it the key to its value. "We expect to prevail in U.S. Tax Court," says a company spokesperson. The IRS declined comment.

Huge StakesHow big are the stakes for companies that may face a similar challenge over their transfer pricing? Numbers are hard to come by, but The Analysis Group's Wright assumes that a typical multinational pharmaceutical company spends 4 percent of its revenues on corporatewide IT and other support services, and spends another 15 percent on marketing and distribution. Under current IRS rules, if those marketing and distribution activities took place in the United States, the U.S. taxpayer could be expected to earn a modest markup on these costs, typically between 5 and 10 percent.

Under the new rules, the company would have to add a markup based on its estimate of what it would pay a third party for those services, recognizing the value created by the services. But the company would have to prove that such a markup was appropriate, based on market prices or "comparables." If it couldn't do so within a margin of error that grows increasingly narrow as the markup rises, tax could very well be owed according to the affiliate's share of the profits earned in the U.S. market, based on its value added; that is, the value of the marketing relative to R&D. In the case of the average multinational drug company, says Wright, if it has a gross margin of 80 percent, such a profit split could mean the U.S. company should earn a significant chunk of the gross profit, or as much as 30 or 40 percent of revenue. That's as much as eight times what the company would report under current IRS rules.

Wright suggests it's safe to assume that roughly the same profit-and-tax analysis applies to multinationals in such industries as technology and chemicals. Many, in fact, besides drugmakers have marketing operations in the United States, which under current rules can be reported at cost or at a modest markup (or "charged out" for tax purposes) without challenge by the IRS—as long as the services performed are nonintegral. Not so under the proposed regulations.

Experts say the IRS's obvious targets are U.S. companies that have set up manufacturing operations in tax havens. Under the new rules, they could get hit with big tax bills based on the profits generated there, if they are deemed to have transferred engineering know-how in the process. In that case, the IRS may require the parent company to report not the cost of the compensation of employees who transferred the engineering know-how plus a markup, but a share of the profit that would reflect the value of a license agreement that a third party would pay for the intangible asset involved, even when the actual terms of the arrangement are contractual.

"The idea," says John Breen, a senior technical reviewer in the international division of the IRS, "is to bring the rules for transferring intangibles embedded in services into line with those for transferring intangibles in general."

Foreign jurisdictions see things differently, at least at present. The current IRS rules are similar to those in the 29 other members of the Organization for Economic Cooperation and Development (OECD). And that means that, should the new IRS rules be ratified, one or more of those foreign tax authorities could add insult to injury. If another OECD member disagrees with the IRS interpretation of proper transfer pricing, the parent or subsidiary in that country would still owe tax on the portion of profit subject to tax in the United States—subjecting that amount to double taxation.

The United States and other OECD members agree that double taxation is unfair, but the process for seeking relief can take up to five years even under current regulations. And because of the additional complications of the proposed rules, says Cognizant's Silvestri, "you're going to add to that [period] by several years."

Battling AbuseSome experts nonetheless concede that the existing rules governing intercompany services, created in 1968 and amended in 1996, are out of date. In essence, these observers say, the IRS is trying to overcome a legal precedent set by the U.S. Tax Court in 1992 in a case involving Westreco, a U.S. subsidiary of Switzerland-based Nestlé, the chocolate giant. At issue was contract research that Westreco did for Nestlé that the latter reported to the IRS at cost plus a percentage markup. While the tax service argued that the reported markup was too low based on the value of the R&D, the court sided with Nestlé.

Now the IRS worries that such arrangements have only grown more numerous as corporate profits increasingly reflect the value of services rather than products. Even some critics of the new rules acknowledge that some companies have engaged in tax abuse by compensating foreign affiliates for valuable services at a much higher price than is appropriate. One reportedly common abuse is to contract with an R&D affiliate in a high-tax country on a cost-plus basis at the outset of the work, and then to restructure the terms once the R&D is successful to provide a subsidiary in a tax haven with much of the profits.

"There are lots of tax plans being sold by consultants who say, 'Hey, you've got all these intangibles in the U.S., and we can show you a way to move them to a tax haven offshore,'" notes Janice Lucchesi, vice president of tax for the Chicago-based affiliate of Akzo Nobel NV, a Dutch manufacturer of pharmaceuticals, chemicals, and coatings products. Still, she contends that existing rules already enable the IRS to go after such abuses. "In those cases, 'TaxhavenCo' didn't pay a high enough price for transferring the assets offshore, and the IRS should go back and adjust the toll," says Lucchesi.

And while the outcome of the Westreco case suggests that the IRS may find that difficult to do, the new rules "cast the net too wide," says Robert Ackerman, national director of transfer-pricing services for Ernst & Young. He notes that the new rules are riddled with ambiguities that could be turned by the IRS into audit weapons with which to pursue additional revenue from companies that aren't engaged in abuse. For instance, the IRS says even back-office services may not qualify for cost-plus treatment if they are "high value," "highly integrated," or "nonroutine"—all terms that Ackerman and other critics say are woefully ill-defined.

The IRS acknowledges that low-margin back-office functions, such as payroll, accounting, and bookkeeping services, may add little if any value beyond their cost savings. But the agency contends that some services—such as those using internally developed software, for example—might have great value and therefore shouldn't be evaluated on a cost-plus basis, even if the apparent markup is sizable. "A markup of 30 or 40 percent might in theory be the right number for such a high-value service," says the IRS's Breen, "but you wouldn't necessarily be able to tell based on the metric used for calculating it." For that reason, the new rules say that if a markup exceeds 10 percent, a company may have to value the service based on the subsidiary's share of the parent's profits or another, more-appropriate method.

In the end, the IRS sees potential tax avoidance where companies see cost savings. Many companies, for instance, manufacture in China to take advantage of inexpensive labor. But they do so under contract instead of a license not for tax purposes, but because they don't want to jeopardize their intellectual property in a country notorious for piracy. "We aren't trying to avoid tax," says one tax executive at a multinational with Chinese operations. "We're simply trying to protect our intellectual-property rights."

Under the proposed IRS regulations, however, companies such as Akzo Nobel would most likely no longer be able to do both.

Ronald Fink is a deputy editor of CFO.

No Ports in This Storm

The new transfer-pricing proposed by the Internal Revenue Service last September would scrap the current safe harbor for services that are "nonintegral" to a company's business. Instead, multinational companies' pricing of such services must reflect not just the cost but also an appropriate markup based on what an independent third party would charge for the services. What's more, if the markup involved in such a "simplified cost-based method" of transfer pricing exceeds 10 percent, the type of service is one of those specifically excluded from transfer pricing according to this method, or is otherwise deemed not to be the "best method" of determining the price, one of five other methods must be employed. Their characterization below is drawn from an article by Thomas M. Zollo, Christopher P. Bowers, and Jeffrey P. Cowan, all with KPMG, entitled "Transfer Pricing for Services: the New Wave Hits," published this month by CCH Inc.

Comparable Uncontrolled-Services Price Method. Under this method, the arm's-length nature of charges for intercompany services would be evaluated using the prices charged in an "uncontrolled-services" transaction for services that are identical or have a high degree of similarity.

Gross Service Margin Method. This method would test whether the amount charged in a controlled-services transaction is arm's length by reference to the gross services profit margin realized in an uncontrolled-services transaction that involves similar services.

The Comparable-Profits Method. This method would apply the arm's-length standard by analyzing the profit-level indicators from financial information regarding uncontrolled taxpayers performing similar services under similar circumstances.

Profit-Split Method. The proposed regulations would extend the use of the comparable profit-split and residual profit-split methods used under current regulations for transferring products to transactions involving controlled services. These methods evaluate whether the allocation of combined profit or loss is arm's length by reference to the relative value of each controlled taxpayer's "contributions" to the combined operating profit or loss.

More Fine Print

Under new rules for transfer pricing that the Internal Revenue Service proposed last September, certain types of service transactions are specifically excluded from the simplified cost-based method, including the following:

Manufacturing, production, extraction, or construction.

Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission arrangement.